I recently had the pleasure of attending a local real estate investors group meeting and listening to a tax accountant discuss his real estate investment strategies. In addition to sharing with the group different tax angles he made a most profound statement that he asked to all of us in the room. He asked us to answer this question; What is your “game plan” for the property?
If you're investing in Real Estate whether the contemplated investment property involved is a condo, a single family home, a multi family rental building, land, or a commercial use property, when you intend to purchase an investment piece of property, what do you intend to do with that property? How do you intend to profit? As he asked of us; what is your Game Plan for the investment property?
This got me thinking why should someone buy investment Real Estate? After some thought I realize that there are (3) three main reasons why one should buy investment properties.
A property that you invest in can produce cash flow today and well into the future. With the right financing and debt service on the property you realize what is called a “cash on cash return”. Since income is derived from rents it is not consider ordinary income to you as far as Uncle Sam is concerned and the rental income is consider “passive income”. Passive Income can be readily sheltered from paying tax on it.
Real Estate is generally considered a hard asset and also an investment that acts as a hedge against inflation. When referring to land, Will Rogers once said “They ain't making any more of it” Owning properties in desirable areas around the country where other people would like to locate creates more demand that is relative to the supply. Restrictive development rights, environmental issues, Urban Growth Boundaries, and designated open space areas further limit supply and cause Properties to increase in value.
These appreciated values create an equity bonanza for the investment property owner. When a property does appreciate significantly, one way you can raise cash is to borrow against the equity you have in that property. This “cash out” refinancing allows you to raise capital and still deduct the interest payments that are used to pay back the loan. However a word of caution, Real Estate does not always go up in value as it often runs in up and down cycles.
3) Tax Benefits
Investment Real Estate ownership has certain tax benefits associated with it that allow you to deduct your maintenance, operating expenses, taxes, and insurance, along with any overall losses which are called “passive losses” and use these loses to offset some of your other ordinary income.
The big tax benefit that is associated with owning investment real estate properties is also called the big “D” which stands for Depreciation. The government allows you to depreciate a little bit of the value of an investment property by a certain percentage each year. Currently you can depreciate over a 27.5-year time frame for residential properties and over 39 years on commercial type properties. Let's assume you purchased a rental home and with the financing you had on the property you could rent it out each month so that the rents coming in would cover all your expenses, taxes, and insurance. You would have what is called a “breakeven” cash flow situation.
Even though you did not lose any money from operating the property as a rental when you add in the depreciation of the property you would now have losses that can be used to offset against other income you earned. These depreciation amounts can generate significant losses for you to use against your other income. You may use up to $25,000.00 in net passive losses per year to offset other income that you earn.
If you are in a higher income tax bracket you can still get the benefit of carrying forward any unused net passive losses above and beyond your $25,000.00 in passive losses already used that can be applied against positive cash flow from other rental properties or any future capital gains when an investment property sells by using IRS form 8582.
Although this code applies to owning your personal residence and not an investment property IRS code # 121 says that you can qualify for up to a $250,000.00 per person home sale tax exemption, or up to a $500,000.00 tax exemption for a married couple filing jointly on any capital gain resulting from the sale of your home if you have owned and occupied your principal residence at least an “aggregate” two years out of the past five years before the sale.
This code is sometimes called the “nomad tax act of 1997” by tax professionals as it has provided incentive to many home owners to turn their personal residences into a rental investment property, then renting it out, and riding the wave of appreciation increases before selling their property years later and using the tax exemption on any capital gains.
Another tax benefit is the use of IRS code, 1031 & 1034 which involves exchanging of investment properties. Use of these provisions in the tax code allows one to defer taxes on sale of their rental properties.
Tax benefits are simply a form of incentives from our government designed to encourage individuals to provide continued investment into real estate properties, and to also provide rental housing.
When you look at the combination and interplay of Income, Appreciation, and Tax Benefits associated with investment real estate you can see why it can be a wonderful vehicle one can use to accumulate and build wealth. Here is a simplified system for you to decide how a prospective investment property fits your “game plan”. We start by creating (3) three designated categories called “A” type, “B” type, and “C” type properties. Let's discuss the characteristics of each of them:
A Type Properties
These are properties that usually well located and structurally sound. They are located in areas that are desirable or becoming desirable. You intend on owning them for a number of years. They will provide you with rental income and tax benefits although they may not provide much positive cash flow initially. These types of properties are what I call “Keeper's” and are owned for the increased future cash flow and appreciation they will bring over the long haul.
B Type Properties
These are properties that are sometimes real “down and dirty”. They have been neglected and have deferred maintenance & needed repairs associated with them. They may be a foreclosure property or some other sort of distress sale. Your time and money also known as “sweat equity” can substantially bring up the value of these properties. They are the types of properties I call “Fixer's”. Your find these types of properties, you fix them, and then you sell them to generate cash profits and cash flow today.
Occasionally a “B” type property you acquire can become an “A” type property through a change of mind. You can then refinance the property pulling out tax free cash that you can use to acquire additional properties or simply hold on to the property by renting it and creating positive rental cash flow.
Finding A & B type properties is no easy endeavor. You will constantly be on the look out for them. You will look at hundreds of properties in your marketplace and in all likelihood make offers on hundreds as well to find one suitable A type or B type property.
C Type Properties
The ultimate game plan in accumulating and building wealth is to obtain these types of properties. Over the years you have gotten rid of your sub performing properties or “dogs” by selling some of your other “A” & “B” type properties and now you have what are known as “C” type properties. These are properties that are free and clear of any debt. They will provide you with a pure cash flow and can be used as a retirement vehicle. They also provide security for you and your family as regardless of what goes on in the financial markets people always will need a place to live and have shelter.
So the next time you are looking at a potential investment property, consider where it might fit into the “A”, “B”, or ultimately “C” type categories and your overall investment goals. Asking yourself the question; “What's my game plan for the property?” is prudent before you get involved and can help you more clearly develop your strategy.